- July 29, 2022
- Posted by: Ramkumar
- Category: Posts
Decline In Corporate Governance
As Russia’s invasion of Ukraine has ruled global headlines this week, two other issues that made my head turn were the episodes involving the National Stock Exchange of India Limited and ABG Shipyard Ltd. In one instance, a 𝐟𝐚𝐜𝐞𝐥𝐞𝐬𝐬 𝐲𝐨𝐠𝐢 𝐡𝐚𝐝 𝐚 𝐂𝐄𝐎 𝐮𝐧𝐝𝐞𝐫 𝐡𝐢𝐬 𝐜𝐨𝐧𝐭𝐫𝐨𝐥. In another example, a firm 𝗰𝗵𝗲𝗮𝘁𝗲𝗱 𝗮 𝗰𝗼𝗻𝘀𝗼𝗿𝘁𝗶𝘂𝗺 𝗼𝗳 𝟮𝟴 𝗯𝗮𝗻𝗸𝘀 𝗼𝗳 𝗥𝘀 𝟮𝟮,𝟴𝟰𝟮 𝗰𝗿𝗼𝗿𝗲𝘀 𝗯𝗲𝘁𝘄𝗲𝗲𝗻 𝟮𝟬𝟭𝟮 𝗮𝗻𝗱 𝟮𝟬𝟭𝟳. However, the banks failed to report this fraud till 2022.
As the standards of 𝗰𝗼𝗿𝗽𝗼𝗿𝗮𝘁𝗲 𝗴𝗼𝘃𝗲𝗿𝗻𝗮𝗻𝗰𝗲 𝗰𝗼𝗻𝘁𝗶𝗻𝘂𝗲 𝘁𝗼 𝗴𝗲𝘁 𝗱𝗲𝗽𝗹𝗼𝗿𝗮𝗯𝗹𝗲, as an investor/analyst, i factor this when valuing companies primarily in the emerging markets in the following ways:
1)𝗧𝗿𝗲𝗮𝘁 𝗯𝗿𝗶𝗯𝗲 𝗮𝘀 𝗮𝗻 𝗼𝗽𝗲𝗿𝗮𝘁𝗶𝗻𝗴 𝗲𝘅𝗽𝗲𝗻𝘀𝗲: When i value companies, especially Chinese/Indian firms, i add an operating expense – bribes to corrupt officials. Further, I am building a model on a firm’s efficiency in bribery and treating it as a competitive advantage for firms that are good at getting results for their bribe payments.
2)𝐓𝐫𝐞𝐚𝐭 𝐂𝐨𝐫𝐫𝐮𝐩𝐭𝐢𝐨𝐧 𝐚𝐬 𝐚𝐧 𝐢𝐦𝐩𝐥𝐢𝐜𝐢𝐭 𝐭𝐚𝐱: In an alternate scenario, i treat corporate Corruption as an implicit tax to do business in that country. PwC comes up with an opacity index that adds an operating cost to do business in a country and converts it to an effective tax. For instance, they estimated the effective tax for China as 46%.
3)𝐈𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐭𝐡𝐞 𝐜𝐨𝐬𝐭 𝐨𝐟 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐭𝐨 𝐜𝐨𝐯𝐞𝐫 𝐠𝐨𝐯𝐞𝐫𝐧𝐦𝐞𝐧𝐭 𝐩𝐚𝐫𝐭𝐧𝐞𝐫𝐬: For a firm in the emerging markets whose biggest customer is the #government, the firm usually gives a share of its profits to corrupt officials. Thus, I increase the WACC of such a firm by a factor, and the firm needs to generate a higher return to offset these cash outflows.
In my view, 𝐩𝐨𝐨𝐫 𝐜𝐨𝐫𝐩𝐨𝐫𝐚𝐭𝐞 𝐠𝐨𝐯𝐞𝐫𝐧𝐚𝐧𝐜𝐞 𝐢𝐧 𝐞𝐦𝐞𝐫𝐠𝐢𝐧𝐠 𝐦𝐚𝐫𝐤𝐞𝐭𝐬 𝐢𝐬 𝐚 𝐫𝐞𝐚𝐥𝐢𝐭𝐲 and analysts/investors must factor in this issue when valuing companies. Therefore, while you may disagree with my above framework, i recommend that analysts add a cost/risk layer when valuing companies in emerging markets that incorporate poor corporate governance.